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What is dividend investing?

Francesco Lavecchia  |  23 Jul 2021Text size  Decrease  Increase  |  
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Dividend investors look for stocks that pay out high dividends, giving them a regular income stream in addition to any growth in the market value of the stock.

There are several reasons for buying dividend payers:

  • Fixed income investments may not provide enough income to overcome the depreciation of your capital in a low interest rate environment.
  • Higher guarantee of cash flow
  • Total return: Dividend accumulation, especially where dividends grow, can boost an investment's total return. According to a Morningstar study focusing on the S&P 500, dividend returns counted for 16 per cent of the total return between 2010 and 2019.

To be eligible for dividends, investors must be a "shareholder of record", the registered owner of a security with the rights, benefits and responsibilities of ownership, such voting at the company's AGM.

Take note that stocks trading "ex-dividend," have already paid out dividends and buyers after this date won't receive the most current dividend payout.

Two ways to invest in dividend stocks

There are two common strategies when it comes to investing for dividends: high dividend yield, or high dividend growth.

A high yield approach picks according to dividend yield. This offers high rewards in the short term but also risks falling into a dividend trap, where dividends are unsustaintable and the firm reaches a point where it can no longer pay dividends, negatively affecting the total return of a portfolio.

This can occur when companies pay dividends from the proceeds of selling part of its business, even while the core business struggles, or when a firm increases its debt to cover its dividend. 

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A high dividend growth strategy also focuses on the quality of the business and financial health of the company. A high quality business should be able to grow profits despite adverse economic trends, and strong financial health often means a company can afford to pay long-term dividends.

At Morningstar we adopt this approach in the construction of the Morningstar Australia Dividend Yield Focus Index. The index constituents are a subset of the Morningstar Australia Index, excluding REITs. It takes the top 25 companies by 12-month dividend yield after screening for narrow or wide economic moat and 'distance to default', a measure of a company's financial stregnth.

The 25 holdings of the Morningstar Australia Dividend Yield Focus Index are expected to provide high-quality dividends. The top six names by weight include the over-valued Wesfarmers (ASX: WES) as well as the fairly-valued gas infrastructure owner APA Group (ASX:APA)

The index does not incorporate Environmental, Social, or Governance (ESG) criteria, but we've created a separate list of names for those who want ESG-friendly dividends

is a research editor specialising in the Italian market.

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